Banking

Passport Capital's gold experiment

Burbank sees contracts broken, prepares to buy physical gold

By

AlistairBarr

SAN FRANCISCO (MarketWatch) -- This summer, John Moran picked up 100 ounces of gold from a locker run by the Comex exchange in New York.

The bars, which were light enough to carry in a backpack, marked the culmination of a $95,000 experiment by Passport Capital, a San Francisco-based hedge fund where Moran is director of business operations and strategy.

Passport, headed by John Burbank, wanted to find out how easy it would be to buy physical gold, rather than futures contracts or gold exchange-traded funds. The firm was also interested in testing conspiracy theories about the availability of the precious metal.

Moran used his own money because Passport didn't want to run the test with its investors' cash. Everything went smoothly. In July, Moran bought a futures contract on 100 ounces of gold at roughly $950 per ounce for delivery in August. When the contract expired, Comex sent him a notice saying the gold was available for collection in New York at a specific time and date.

With gold prices down from a recent record, Passport is poised to repeat the process on a bigger scale for investors in its $1.2 billion Global Strategy hedge fund.

Like several other hedge fund managers, Burbank sees inflation from trillions of dollars that have been pumped into the global economy by the Federal Reserve and other central banks in the wake of last year's financial crisis.

Gold may be a good hedge against this and physical gold could be an even better investment if the financial system runs into trouble again, Burbank reckons.

"A year and a few months after the crisis, there's no recognition that we have to change," he said in an interview. "Instead, the U.S. is borrowing and spending again, like a rogue trader doubling down."

"We're liable for another collapse of some sort," he added, noting that "physical gold could go to very high levels" in such a scenario.

Gains and losses

The firm has invested in gold ETFs like the SPDR Gold Trust
GLD, -0.88%
and gold mining companies since about 2002. However, it sold its gold ETF positions recently and has been waiting for prices to slide so it can buy physical gold, possibly before the end of 2009, Burbank said.

Burbank's research into gold and the modern financial system led him to a big bet against subprime mortgage securities. That generated returns of 220% for Passport's main hedge fund in 2007, according to a recent investor update obtained by MarketWatch.

However, Passport was particularly hard hit last year, when the mortgage meltdown grew into the worst global financial crisis since the Great Depression. Passport's Global Strategy fund lost 50.9% in 2008 and it has yet to recoup some of those losses, returning just over 17% this year, through October. Still, the fund has gained more than 24% a year since it started in 2000. Burbank declined to discuss performance.

No contracts

Despite a recovery this year in the stock market and the economy, Burbank sees a risk that contracts will be broken. This could happen to contracts between counterparties on either side of investments or between heavily indebted sovereign nations with lots of unfunded future liabilities and individuals or investors in those countries, he explained.

Owning physical gold is an insurance policy against such financial catastrophe because it involves no contracts. In contrast, gold futures and ETFs are just types of paper contracts that could be broken in a crisis, according to Burbank.

"If someone can't pay, an exchange closes or a counterparty goes bankrupt, you don't actually own gold in those situations," he said. "And that's when you want to own it most."

Delivery

Passport reckons physical gold prices could rise more than gold futures and ETFs as more investors demand physical delivery when futures contracts expire.

Indeed, the firm argued in a research note earlier this year that the price of gold futures has little connection to the actual metal because about 99% of contracts are settled in cash.

For most commodities, like copper, oil or corn, taking physical delivery and storing the stuff is tricky and expensive. But gold is much more portable and storable. All the gold ever mined would fit into a cube roughly 65 feet per side, Passport estimated.

"There could effectively be a global run to physical gold as people simultaneously converge on gold markets and demand delivery," the firm wrote.

That could trigger a surge in physical gold prices, a bit like a short squeeze which forces traders to close bearish bets by buying back shares they've borrowed and sold, Passport explained.

"For investors to profit from a short squeeze in gold they must be in a position to deliver physical metal," the firm added. "Having a paper substitute for gold may not necessarily provide the same results."

In February 2005, new Comex rules allowed delivery of gold-backed ETFs instead of physical gold to settle a futures contract, creating a "pressure release valve" in the even of a short squeeze, Passport noted.

Cheaper

Passport also favors physical gold because it's cheaper than investing in the metal through an ETF.

Owning physical gold through a bullion bank costs 5 to 30 basis points a year, while gold-backed ETFs charge roughly 40 basis points, Passport noted in its research report. (A basis point is one hundredth of a percentage point).

Even if investors follow Passport's experiment and take Comex futures contracts to delivery, then leave the gold bars with one of the exchange's depository institutions in New York, it will cost them less than 30 basis points a year, the firm added.

This may be the case even though Passport is planning to pay extra to have its bars "allocated." This means the gold is segregated from other investors' gold in vaults. The act of allocation moves the title of the metal from the bank to the investor.

In an unallocated account, investors have a general claim on the bullion bank for a certain amount of gold. Investors who own gold this way assume counterparty risk with the bank. If the institution goes bankrupt, these investors have to get in line with other creditors to get their gold, "or whatever is left of it," Passport explained.

Canada, Norway, Australia

Once Passport buys physical gold, the firm is planning to store it in countries like Canada, Norway or Australia, which are politically stable, resource rich and fiscally fitter than the U.S.

The firm has a big framed replica of Franklin D. Roosevelt's 1933 declaration banning private ownership of gold hanging by the bathrooms at its headquarters near the Transamerica building in downtown San Francisco.

Americans were ordered to turn in most of their gold to the government, which gave them almost $21 for each ounce of the metal.

Soon after, Roosevelt changed the conversion price to $35, "an act of taxation by inflation that effectively transferred 40% of the gold held by the Fed for American citizens to the U.S. government," Passport wrote in its research note earlier this year.

While another crisis may be resolved without governments resorting to such draconian measures, Burbank reckons investors should try to establish residency in politically stable countries with little debt, such as those in Scandinavia or New Zealand.

"People should establish residency in other places like this as a 'life hedge' if they can," Burbank advised.

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